Maintaining discipline in volatile times

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If market ups and downs cause you to question your portfolio decisions, you likely aren’t alone. In our experience, market volatility creates portfolio management challenges for many. Sharp downdrafts can cause many investors to head for the exits, whilst boomlets in select assets often stir excitement about hot potential opportunities. Fear of declines — and fear of missing big gains — are powerful motivators, in our view. But both are reactions to past performance — a big potential error in investing, as past returns don’t dictate the future. In our view, muting your reaction to the recent past, whether it stokes fear or greed, can help you reduce the risk of that error.

In our experience, volatility can trigger a desire to take action, potentially causing folks to trade at inopportune times. Exhibit 1 illustrates this point by overlaying global equity returns and net flows in and out of US open-ended investment companies and exchange-traded funds (ETF) since this data series begins in mid-2016. Whilst it is a short sample, it does include a full equity market correction (sharp, sentiment-driven drop of around -10% to -20%). As the chart shows, U.S. investors broadly poured money into equities until mid-Feb. 2018. Coincidentally, this was two weeks after global markets peaked when measured in USD. Throughout the year’s first half, flows jumped and dived alongside equity markets, suggesting investors trying to trade around the volatility. In December, outflows sharpened as the correction hit fever pitch. Yet even as equity markets began recovering after Christmas, fund flows stayed broadly negative. Whilst it isn’t a certainty, we think this shows investors not only reacted to ongoing volatility as it occurred, but remained scarred by 2018 and missed the chance to recoup some of those declines. In our view, this is a striking example of the trouble with reacting to volatility.

Exhibit 1: Fund flows suggest investors reacted to volatility

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Older fund flow data, which exclude ETFs, imply similar behaviour. For example, there were net outflows each quarter in 2008. Markets declined each quarter as the global bear market approached its low point in Q1 2009. Outflows peaked in Q4 2008, during the throes of the bear market, as fear of continuing declines seemingly drove many investors away. Now, for some, selling may not have been a mistake. Those able to avoid declines in 2008’s bear market and re-enter at a lower point before the new bull market gained steam possibly benefitted. But the relative dearth of fund inflows during late 2008 and early 2009 — as well as our experience during this stretch—suggest this was rare. In our view, many investors got more frightened as markets declined, sitting on cash and awaiting a rebound for signs of “stability.” Q3 2011’s correction had a similar impact. Volatility rose as many focused on America’s debt ceiling fight that summer, which culminated in credit rating agency Standard and Poors’ downgrading of the US’s AAA rating. Outflows spiked just before markets resumed their rise. Similarly, sharp declines in Q4 2018 also coincided with outflows, as many appeared to fear a global economic slowdown. Yet markets quickly bounced back.

But it isn’t just negative volatility that creates problems. Similar pitfalls possibly await investors tempted to chase the latest hot categories’ past performance. Consider gold and silver earlier in this global equity bull market. These two commodities rose hugely during the bull market’s early years, only to peak in 2011. Exhibits 2 & 3 use GLD and SLV—two American exchange-traded products offering exposure to gold and silver, respectively, to illustrate this. As shown, the large rise in net inflows implies to us investors saw flashy performance and dove in. Our experience at the time echoes this, with many justifying their heightened interest through various narratives pro-gold and silver financial pundits popularized. But when gold and silver prices headed south—rapidly—outflows followed suit. Latecomers to the gold party could very well have bought high expecting prices to go higher, only to get big declines.

Exhibit 2: Acting on hot categories presents challenges - gold edition

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Exhibit 3: Acting on hot categories presents challenges — silver edition

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Of course, returns — good and bad — do occasionally persist for some time. It is possible that investing based on past returns may work in the near term. But this is, in our view, a function of luck. Past returns aren’t indicative of future results. We think it is an investing process error to base a buy or sell decision exclusively on past returns.

Instead of closely tracking past returns — which can drive errors — we think looking forward is key. Instead of projecting past movement, we suggest asking yourself what is behind the movement. Will those factors persist? Are they fundamental and lasting or brief sentiment blips? If the latter, chasing the past could be damaging to your portfolio.

Fisher Asset Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein

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